Dairy production is a major activity in the livestock sector and an important source of livelihood for about 600,000 small-scale farmers. Apart from milk, dairy animals also provide manure, other marketed products such as calves and cullings as well as other intangible benefits such as insurance and status symbol. In 1995, the value of dairy production was estimated at Ksh 23.1 billion equivalent to 14% of total value of agricultural production (Kodhek, 1999). In 2000 milk production was estimated at 2.3 billion litres of which 63% was marketed, 30% was consumed at home and the rest 7% fed to calves (Republic of Kenya, 2002).

The value of this production is estimated at Ksh 35.2 billion equivalent to 25% of gross agricultural output recorded in 20001. Despite this significant contribution to the national economy and households incomes, the dairy industry is besieged by a number of technical, economic and institutional problems, which seems to have escalated in the recent past. Although smallholder dairy production contribute over 56% and 70% of total and marketed milk production, respectively Omore et al, 1999), the productivity per animal in these farms remains low.

Erratic payments, low farm gate prices and low sales as a proportion of total production especially evening milk, unreliable market outlets and limited access to veterinary and A.I services are all factors that negatively affect productivity and performance of the dairy sub-sector. However, the potential for increasing dairy productivity in the country and especially the smallholder dairy remains great. For instance, the average yield per cow in smallholder farms is as low as 1,300litres per year as compared to the best world practice of 4000-6000 litres.

Increased productivity in the dairy sector will not only enhance farm incomes, nutrition, reduce poverty but will also supply dairy products to the growing urban populations. According to the current development plan, Kenya’s population was approximately 30.4 million people in 2001 and it is estimated that in 2008 the population will be 35.4 million (Republic of Kenya, 2002). By then, it is estimated that the country’s milk demand will be around 2.6 billion litres as compared to the current demand of around 2.1 billion litres. This calls for not only higher production but also better organisation of the marketing chain.

Since the liberalisation of the dairy industry in 1992, new institutional arrangements in milk collection, processing and marketing have emerged. At the farm gate level, informal marketing channels dominate with most farmers using this channel. These channels include hawkers, brokers, self-help groups as well as neighbours and business establishments like hotels. In total, the informal market channel is estimated to control 60% of the total marketed milk. Dairy co-operatives, which used to be an integral part of the formal milk collection and marketing, have been relegated to buyers of last resort.

Furthermore, the cooperatives are also marketing a big proportion of their milk directly to urban markets. The 45 licensed milk processors with an estimated daily intake of 600,000 litres handle the rest of the market share. This is as compared to over one million litres per day, which Kenya Co-operative Creameries (KCC) used to handle during its peak. In as much as these new institutional arrangements in milk marketing have offered expanded business opportunities and enhanced competition, they do offer major challenges to the growth and development of the dairy industry.

The informal marketing channels not only expose the public to heath and hygiene related risks but also continues to stifle the growth of the formal milk sector. For instance, out of the installed milk processing capacity of 2.2 million litres per day only about 26% of this capacity is currently being utilised. This has limited value addition in the milk chain while contributing towards increasing consumer prices for packaged milk.

The internal production, processing and marketing constraints have also played a major role in diminishing the competitiveness of the dairy sector in Kenya. This has occurred to the extent where milk powder imports are said to out-compete locally produced milk. This development not only constrains the domestic milk market but also closes opportunities for expanding export market.

This paper re-evaluates some of the aforementioned issues. The objective is to identify areas of relevance to public policy, which can be used to increase productivity and efficiency along the milk supply chain. Specifically, this paper first reviews the supply and demand situation in the country. It is followed by an evaluation of milk production (supply) issues ranging from cost of production and competitiveness of the various production systems. A hybrid of the structure-conduct performance and new institutional economics is then applied to analyse the various milk-marketing channels. Of special interest are the levels of market concentration, marketing margins, investments along the milk marketing chain and the co-ordination of the chain.

The paper also evaluates the international trends in dairy production, processing and marketing. The evaluation is aimed at identifying challenges and opportunities for development of a dairy export strategy in Kenya. The final section highlights some of the challenges that confront the dairy industry in the post-liberalisation era.